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Five Years After Dodd-Frank: Unintended Consequences and Room for Improvement

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Five Years After Dodd-Frank: Unintended Consequences and Room for Improvement University of Pennsylvania ScholarlyCommons Wharton Public Policy Initiative Issue Briefs Wharton Public Policy Initiative 12-2015 Five Years after Dodd-Frank: Unintended Consequences and Room for Improvement David A. Skeel University of Pennsylvania Law School, [email protected] Follow this and additional works at: https://repository.upenn.edu/pennwhartonppi Part of the Economic Policy Commons, and the Public Policy Commons Recommended Citation Skeel, David A., "Five Years after Dodd-Frank: Unintended Consequences and Room for Improvement" (2015). Wharton Public Policy Initiative Issue Briefs. 11. https://repository.upenn.edu/pennwhartonppi/11 This paper is posted at ScholarlyCommons. https://repository.upenn.edu/pennwhartonppi/11 For more information, please contact [email protected]. Five Years after Dodd-Frank: Unintended Consequences and Room for Improvement Summary This brief offers a 5-year retrospective on Dodd-Frank, pointing out aspects of the legislation that would benefit from correction or amendment. Dodd-Frank has yielded several key surprises—in particular, the problematic extent to which the Federal Reserve has become the primary regulator of the financial industry. The author offers several recommendations including: clarification of the rules yb which strategically important financial institutions (SIFIs) are identified; overhauling the incentives offered to banks; instituting bankruptcy reforms that would discourage government bailouts; and easing regulatory burdens on smaller banks that are disproportionately burdened by the SIFI designation process. Keywords Dodd-Frank, Federal Reserve, financial reform, banks Disciplines Economic Policy | Public Policy License This work is licensed under a Creative Commons Attribution-Noncommercial 4.0 License This brief is available at ScholarlyCommons: https://repository.upenn.edu/pennwhartonppi/11 publicpolicy.wharton.upenn.edu Five Years after Dodd-Frank: ISSUE BRIEF VOLUME 3 Unintended Consequences and NUMBER 10 Room for Improvement DECEMBER 2015 David Arthur Skeel, JD The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), signed into law on July 21, 2010, was a sprawling, imperfect, 2300-plus page response to the worst financial crisis in the U.S. since the Great Depression. It likely will be the only major financial reform legisla- tion for the next generation, so it warrants regular ret- SUMMARY rospectives. Marking the law’s significant anniversaries • This brief offers a 5-year retrospective on Dodd-Frank, pointing gives policymakers an opportunity to evaluate areas for out aspects of the legislation that would benefit from correction correction and amendment. or amendment. SURPRISES AND UNINTENDED • Dodd-Frank has yielded several key surprises—in particular, the extent to which the Federal Reserve has become the primary CONSEQUENCES IN THE FIRST FIVE YEARS regulator of the financial industry. This reflects a problem, namely that the regulatory framework established by Dodd- Five years after passage, many of Dodd-Frank’s rules Frank violates the requirements of the rule of law. It relies too remain unwritten and some still await proposal, which is heavily on regulatory discretion, is insulated from effective oversight, and eschews transparency. not surprising given the number of issues and agencies involved in writing and implementation. As of the fifth • In light of Dodd-Frank’s departures from rule of law, the legisla- anniversary in July, only 63% of rules had been finalized, tion could be improved in several ways: by clarifying the rules while about 20% had missed deadlines, the majority of by which regulators designate entities as strategically important financial institutions (SIFIs) and require their creation of living which concern derivatives and mortgage reforms (Figure 1 wills; providing better incentives for banks to downsize more 1). What is surprising, however, is that there is still efficiently; curbing incentives for banks to shift key operations so much regulatory pressure on systemically important to the shadow banking system; instituting bankruptcy reforms financial institutions (SIFIs), particularly big banks. that would discourage government bailouts; and easing regu- Many insiders expected from the outset that banks latory burdens on smaller banks that are disproportionately would be inducing regulatory rollbacks by now, but that burdened by the SIFI designation process. 2 has not happened. There are many reasons why regulators’ policing efforts remain aggressive and why the U.S. is not moving publicpolicy.wharton.upenn.edu in a less regulatory direction after five the case of bonds and is leading to increased scrutiny into banks with years, but three causes stand out. The liquidity issues in the bond market global trading operations at a time first is the London Whale incident because banks have cut back on per- when U.S. agencies were in the midst of 2012, which single-handedly missible and borderline bond trading of Dodd-Frank rulemaking. accounted for the severity of the as they have shed their proprietary The third explanation for the Volcker Rule. The London Whale, a trading businesses. As more and more current regulatory climate is Sena- nickname given to JPMorgan trader activity moves into the shadow bank- tor Elizabeth Warren (D-MA). The Bruno Iksil, whose job entailed trad- ing system, proprietary trading could election of Warren to the Senate was ing for his firm’s own account (i.e., become less regulated (and more an unintended consequence of critics’ proprietary trading), developed an elaborately disguised), defeating the successful derailment of her nomi- excessively large position in the credit initial intentions of the Volcker Rule. nation to head the new Consumer default swap market that had to be The second spur for the surpris- Financial Protection Bureau (CFPB), written down as a loss. When the dust ingly aggressive Dodd-Frank rule- which was inspired by Warren’s own settled, the activities of this one trader making is the LIBOR scandal, a research as a Harvard professor. If 3 caused a $6.2 billion loss for his firm. story that broke on the heels of the Warren had been approved as the first This type of high-capacity, high-risk London Whale. Several British and CFPB head, she wouldn’t have run for trading within commercial banking international news agencies exposed the Senate. Since joining Congress in and lending institutions like JPMor- widespread, fraudulent manipulation 2013, Warren has deftly utilized her gan is what the Volcker Rule seeks of LIBOR rates in trades between big new platform and committee posi- to eliminate by limiting proprietary banks, which colluded for over two tions, particularly her role in the Sen- trading and separating it from a bank’s decades to boost appearances of cred- ate Committee on Banking, Housing, normal, market-making and client- itworthiness and to increase profits and Urban Affairs, to champion tough based activities. How the rule will from this rate rigging. U.S. deriva- financial regulation and consumer 4 work in practice is not so clear cut. tives—a several hundred trillion dollar protection among her colleagues and An unintended consequence of market—and other financial products in the media. The CFPB, which she Dodd-Frank is that the Volcker Rule benchmark their interest rates on also helped to implement as an advi- already has pushed several critical LIBOR, so this manipulation affected sor to the President, has been a valu- banking functions into the shadow markets and consumers around the able and necessary innovation, but the banking system and it likely will con- world, but especially in the U.S. The Bureau does have a designated source 5 tinue to do so. Big banks appear to British government gained oversight of funding and a centralized structure, be retrenching on some of the opera- of LIBOR after much investigation, which makes overturning any of their tions the law permits them to engage and new regulations soon passed the decisions difficult. The CFPB will in, such as market-making and trading U.K. Parliament. In the U.S., this inci- need to avoid mission creep in the for clients. This is especially true in dent and the London Whale scandal long-run to avoid becoming another NOTES 1 http://graphics.wsj.com/dodd-frank-anniversary/. bank financial intermediaries that perform many of the among other types of non-financial entities. 2 One major exception is the so-called “swaps pushout” rule. same functions commercial banks do, but without oversight. 7 For more information, see Susan Wachter, “Next Steps in This would have required banks to move their derivatives Shadow banks raise funds to buy assets, but they have no the Housing Finance Reform Saga,” Penn Wharton Public trading out of their commercial bank subsidiaries, but was deposit insurance and no recourse to the Federal Reserve Policy Initiative Issue Brief, March 2015: http://publicpolicy. repealed as part of budget legislation. in a crisis. Examples include hedge funds, money market wharton.upenn.edu/issue-brief/v3n2.php. 3 http://www.bloomberg.com/news/articles/2015-05-21/ mutual funds, structured investment vehicles, and many 8 For more information on bank stress-tests, see Itay Gold- jpmorgan-directors-don-t-have-to-face-london-whale-loss- other types of entities. (For more, see: http://www.imf.org/ stein, “Disclosure of Bank Stress-Test Results,” Penn Whar- claims. external/pubs/ft/fandd/2013/06/basics.htm). ton Public Policy Initiative Issue Brief, June 2013: http://
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